By Robin S. Davis, CFP®
Some families, especially the very wealthy, prefer to leave some of their estate directly to their grandchildren, thus “skipping” the generation that would include their own children. This is known as a Generation-Skipping Transfer (GST), which would trigger a Generation-Skipping Transfer Tax (GST tax). This tax is piled “on top” of any estate taxes and other gift taxes owed.
Prior to 1976, a grandfather would pass his assets to his son, which would trigger an estate tax, who would then pass the same assets to his son, which would trigger a second estate tax. Some people figured out that if they passed these assets directly to the grandson (known as the skip person) they would ultimately “skip” one generation of taxes. The Internal Revenue Service (IRS) caught on to this “missed taxation opportunity” (as it seems they always do) and created the Tax Reform Act of 1976, which includes a complex series of rules designed to tax the second generation “as if” the first generation had received the money.
In 2008, you may leave up to $2 million to your grandchildren or grand nieces/nephews (or anyone who is at least 37.5 years younger than you, if not related) free of the GST tax. Any amount over this exemption would be taxed at the current tax rate of 45%. Therefore, the key to saving taxes, by sending money far ahead by gifting money now or at your death to the second generation, is to utilize the full exemption. This is especially important as we near the end of 2008 because the exemption in 2009 will increase to $3.5 million. Although these rules are completely repealed in the year 2010, which means you will be able to pass 100% of your estate to whoever you wish with zero estate, gift and GST taxes due, they will be returning in the year 2011. There are rumors that certain members of Congress are trying to “lock-in” the $3.5 million dollar exemption for its return in that year.
There is an additional benefit if you happen to be a “young and wealthy” grandparent with time on your side. If you gift money to your grandchild while you are living by placing assets into a trust, where all benefits accrue to the grandchild, all future growth of those assets pass to him/her free of the GST tax. For example, you may place $2 million of assets in an irrevocable trust for “little Johnny” today that may be worth $10 million upon your death after compounding over the years, all of which would be free of taxes.
If a total of more than $2 million are Generation Skipping Transfers by the grandparent, either directly while living, through a will, or by way of a trust, the grandparent/donor would pay the tax outside of the gift. If the same amount is gifted to a second generation through a family trust set up to benefit the donor’s children as well as grandchildren, the inheritances to the grandchildren is considered a distribution of the estate and they would pay any GST tax out of the gift.
There are other ways you can minimize the GST tax: The IRS rules as of 2008 allow you to gift $12,000 each year to as many people as you wish prior to December 31st without incurring any gift, estate or GST tax (certain requirements must be met if this annual gift is placed in a trust for the GST exemption to apply); you may pay education costs and/or medical costs directly to the respective institutions on behalf of a “skip person” (education costs include tuition only, and medical costs can include medical insurance premiums). Keep in mind that all gift figures given in this article are doubled for married couples.
If used properly, the GST option can benefit very large estates. However, as with most IRS codes, this benefit comes with very complicated rules. Some examples would include, but are not limited to, the following: As mentioned earlier, giving more than the exempted amount could become a tremendously expensive gift as the GST tax is piled on top of estate and other gift taxes at 45%; Naming grandchildren as beneficiaries on your Individual Retirement Account (IRA) may trigger the GST tax; and Family Trusts may also unintentionally trigger the tax, which would warrant doing separate grandchildren’s trusts instead.
As always, for the above reasons, I highly recommend clients seek qualified estate planning counsel since utilizing the GST exemption is an important planning consideration and requires expert legal and tax advice.